Share this

Read more!

Get our weekly email

Enter your email address

The
reason why most people believe that it is impossible for economies such as ours
to grow faster than 2% to 3% per annum at best - and why it is likely that we
will not even do as well as this over the coming years - is that these beliefs
are largely founded on two assumptions which are simply not correct. These are:

1.A It
does not make much difference what we charge the rest of the world for the
goods and services we sell to them. They will always sell in roughly the same
quantities whatever price we ask our export customers to pay for them, so the
exchange rate makes little difference either to our competitiveness, our trade
balance or to our growth prospects and its level does not therefore matter much
if at all. Anyway, the exchange rate is fixed by market forces over which
governments have little or no control.

1.B All
types of investment produce roughly the same returns to whoever finances them.
It does not therefore make much difference where within the economy investments
are made. The returns for the economy as a whole tend to be more or less the
same for all sorts of investment projects, so there is no great benefit in
prioritising some forms of investment over others.

It
is because both these assumptions are wholly unfounded that there is so little
understanding either among politicians, the civil service, commentators or the
academic world as to why the UK
economy has for a long time performed so relatively poorly and what needs to be
done to make it achieve much better results.

Competitiveness

The
reality is that most international trade, although not all, is hugely price
sensitive, particularly the majority of it which consists of relatively
low-tech manufactured goods. Some manufactured products are not very price
sensitive – including most of those the UK now exports, such as arms,
aerospace, pharmaceuticals and vehicles. This is because they are protected by
a combination of complex supply chains, large amounts of accumulated
development and production expertise, first mover niche protection, extensive
intellectual property rights, highly developed brands, politically determined
procurement policies – and sometimes by exceptionally good management. It is
for these reasons that they still exist in the UK. Industries without these advantages
have nearly all been driven out of business. Most manufacturing in our
globalised world is not, however, protected in any significant way. The
production techniques employed are widely known and available. The key
expertise involved then lies in developing and distributing the products which
are manufactured. Where they are made depends very largely on where they can be
produced at the cheapest price, allowing for quality and reliability.

Typically
for most manufacturing operations, about one third of costs are raw materials
and depreciation. For these inputs there
are world prices. The remaining two thirds of total costs – the cost base - are
incurred in the domestic currency, which of course in the UK’s case is
sterling. These cover everything from labour costs to charges for premises,
from bought in services such as cleaning and accountancy to transport and
energy costs, from interest charges to the profit needed to keep businesses
viable. The price we charge the rest of the world for all these costs is almost
entirely determined by the exchange rate. If we want to keep up with the rest
of the world and to avoid our economy stagnating, we therefore have to ensure
that we have an exchange rate which allows us to charge out our cost base at a
competitive rate – allowing for the productivity of our labour force compared
to those in other countries.

There
are at least three immediate ways of telling whether our economy has a
competitive cost base or not. One is to
observe the trends in our share of world trade. The second is to measure
directly the cost of producing a wide variety of manufactured goods in the UK compared to
the prices at which they are available on world markets. The third is to
observe the proportion of the UK
economy devoted to the types of manufacturing which do not have the forms of
protection described above.

Readily
available statistics then tell the story. Our share of world trade, which was
10.7% in 1950 had fallen to barely half this figure by 1980 and has now halved
again, as uncompetitive export pricing has dragged down our growth rate. Direct
measurement of the costs of a wide range of manufactured goods suggests that
they cost at least 20% more to produce in the UK than on world markets, if we can
still produce them at all. As a share of our economy manufacturing – over 30%
as late as 1970 – is now down to barely 10%, and of this percentage well over
half is taken up by output of goods whose markets are in one way or another
protected. What has gone from the UK is nearly all the production
which does not fall in this category.

The
reality is that we have been trying for far too long to sell our output,
especially of manufactured goods, at far too high prices on world markets and
we have priced ourselves out of the market by charging much too much. In
particular, we have tried to sell our labour inputs, allowing for productivity
which is a combined factor of education, training, and the capital equipment we
have available for it, at far above world prices. This is why we have so much
of our labour force which is either employed at very low wages or out of work
altogether. Those lucky enough to be endowed with sufficient skills and
connections can still compete but millions of people who could, given the right
exchange rate, be gainfully employed are consigned – completely unnecessarily -
to life without high quality work.

Returns
on investment

As
to investment, far from all of it producing roughly the same return to the
economy, the reality is that there are huge variations. Most public sector
investment – housing, schools, hospitals, roads and public buildings – produces
barely sufficient returns to cover the interest charges involved in financing
it. Investment in the service sector is more variable but the total returns to
most of it is still very modest. Nowadays, a high proportion of business
investment is being deployed on projects such as building office blocks and
opening new restaurants, none of which produce huge returns to the economy as a
whole. The difference between investments of this sort and those in light
industry – and some parts of the service sector such as those producing
innovative IT applications – is that they largely depend on doing what was done
before more efficiently, which is possible but incremental in scale.
Improvements in output of this sort are, however, quantitatively different from
what happens when technology, usually embodied in machinery, is employed to
produce perhaps twice as much as was produced before with the same inputs.

The
key to getting the economy to grow faster, therefore, is to get as much
investment as possible concentrated in sectors of the economy where the
application of technology can produce the highest returns to the economy as a
whole. This tends very strongly to be in light manufacturing – and also in
related parts of the service sector - where big productivity increases are
spread out not only in returns to those who provided the necessary financial
resources, but also in higher wages, larger profits, more taxable capacity and
better products. The key to getting investment of this sort carried out – and
on a sufficient scale – is to make it highly profitable: exactly opposite to
the condition which prevails at the moment in the UK.

How to
get this done

The
problem is how to make the sort of investment we need most profitable enough to ensure that it is undertaken on a
sufficient scale and – where there is competition for resources - in preference
to other forms of investment with much lower rates of return. The answer is
that investment in manufacturing, particularly light industry, which would then
be capable of increasing both exports and import substitution to the extent we
need, has to be made much more financially attractive – and by far the most
effective way to do this is to have a much lower exchange rate. This automatically reduces all the costs in
sterling – typically about two thirds of the total - which have to be charged
out to the rest of the world in export prices, or which inhibit goods currently
being bought from abroad being made in the UK because it is so much more
expensive to produce them here than in other countries.

If
we are going to be able to pay our way in the world, and to avoid the endless
balance of payments problems we have, which suck demand out of our economy,
encourage borrowing, and constrain the rate at which our economy can grow, we
have to increase the proportion of our GDP which comes from manufacturing from
around 10% to 15%. About 60% of all our exports and 75% of all our imports are
goods rather than services and for both exports and imports about 80% of all
these visible goods are manufactures rather than fuels or raw materials. Thus
the only practical way to get our foreign payments back into balance is for us
to sell more manufactures overseas and to produce more in the UK of those we need for our own
consumption.

How
much adjustment to our exchange rate would be required to bring about the
changes in profitability incentives we so badly need? Because sterling is still so over-valued, to
make major investments in manufacturing capacity viable financially, sterling
would have to come down to about $1.10 or about €0.85. Is this possible? It
certainly would be if the government realised what needed to be done and was
sufficiently determined to make sure that it happened. Some fairly simple
calculations then show what could be achieved between, say, 2015 and 2020 with
a competitive exchange rate instead of what we have at the moment. Economic growth
over this period would be 4% to 5% per annum instead of 1% - a cumulative
increase of over 25% compared to 5%, allowing us to keep up with the rest of
the world instead of constantly falling behind. Gross investment as a
percentage of GDP would rise by about 10% of our national output. Unemployment
would fall towards 3% and living standards would increase by about 3% per annum
instead of stagnating as they are now. The government deficit would fall from
close to 6% of GDP to an easily manageable 3%, so that total government debt
would fall over the next decade to about 60% of GDP instead of rising to more
than twice this percentage as will happen under current policies. Government
expenditure as a percentage of GDP would fall from its current 45% to about 40%
but there would be much more to spend on providing services instead of paying
interest charges. Inflation would probably be slightly higher – averaging
around 3% rather than 2% - while the Gini coefficient, the most widely used
measure of inequality, would drop from its current 36 to about 30 as both
regional and socio-economic inequality fell towards the sort of level seen in
the 1950s and 1960s.

All
of this is possible. Why don’t we make sure that it happens?

This article is part of the There is an Alternative series. An economist and entrepreneur, John Mills is
Chairman of JML. He recently established The Pound Campaign
to raise awareness of the uncompetitive exchange rate and the effect it is
having on UK
manufacturing and the wider economy.